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In 2007 the IRS issued a Notice of Deficiency. It determined Taproot was taxable as a C corporation for 2003 the Roth IRA was an ineligible shareholder.

As a general rule, an S corporation is subject to “flow through” taxation. This treatment comes with a myriad of requirements. Some of which include restrictions on the type of entity eligible to be a shareholder. The list of eligible shareholders has been in flux since the inception of the S corporation. Eligible shareholders generally include: domestic individuals, estates, trusts, and other exempt organizations. If a shareholder is ineligible, the corporation automatically loses its status as an S corporation and becomes a C corporation.

In 2003, no statute or regulation explicitly prohibited a traditional or Roth IRA from owning S corporation stock. However, in Rev. Rul. 92-73 the commissioner concluded that a trust which qualifies as an IRA is not a permitted shareholder of an S corporation.

A Revenue Ruling is a published agency interpretation of the tax law issued by the IRS. Revenue Rulings are not binding on courts.[1] Rather, the rulings are given weight based on their persuasiveness and the consistency of the IRS’s position on the issue over time.

The Tax Court found Rev. Rul. 92-72 persuasive and the Circuit Court agreed. In the revenue ruling, IRS reasoned that IRAs cannot be S corporation shareholders because any income is not taxed currently. The Courts agreed the rational was sound. The Tax Court noted that the taxpayer’s interpretation would shelter the profits from income taxation. Moreover, the Courts determined that the IRS’s position on the issue had been consistent.

The Tax Court also determined that there was no evidence Congress intended for IRAs to be eligible shareholders as IRAs are not explicitly listed in IRC Sec. 1361 (which has been historically a closed rather than open list) as eligible S corporation shareholders.

However, the Court of Appeals felt the Tax Court did not adequately address the taxpayer’s argument that the Roth IRA was not the shareholder, but rather the beneficiary of the IRA was and as a domestic individual was eligible. The taxpayer argued retirement accounts cannot be distinguished from their beneficiaries as individual taxpayers. The argument carried enough weight to warrant a thorough discussion, but ultimately failed.

The Circuit Court determined that the IRS had consistently excluded entities which are not currently taxed on their income from being eligible S corporation shareholders. More specifically the court noted that, IRS has consistently maintained that an eligible shareholder is taxed currently on the S corporation’s income.

While it’s certainly possible a different court could have come to a different conclusion, we believe the correct conclusion was reached. The S corporation is an important element of the code to encourage taxpayers to organize or continue to conduct business in the corporate form.

Moreover, Roth IRAs are an important vehicle through which Congress encourages retirement savings. However, the clever combination of the two reaches a difficult result. To allow taxpayers to remove profits from certain corporations tax-free gives such businesses an unfair advantage. Such an arrangement would interfere with the private economy, without realizing a clear policy goal.